Question No. 2 - IBO-06 - INTERNATIONAL BUSINESS FINANCE - Master of Commerce (M.Com)

Solutions to Assignments 

IBO-06 - INTERNATIONAL BUSINESS FINANCE

Master of Commerce (M.Com) - 1st Year

Question No. 2
a) Explain the mechanism of money market hedge for managing transaction exposure.

The money market hedge allows the domestic company to lock in the value of its partner’s currency (in the domestic company’s currency) in advance of an anticipated transaction. This creates certainty about the cost of future transactions and ensures the domestic company will pay the price that it wants to pay.

Without a money market hedge, a domestic company would be subject to exchange rate fluctuations that could dramatically alter the transaction’s price. While changes in exchange-rate rates could cause the transaction to become less expensive, fluctuations could also make it more expensive and possibly cost-prohibitive.

A money market hedge offers flexibility in regard to the amount covered. For example, a company may only want to hedge half of the value of an upcoming transaction. The money market hedge is also useful for hedging in exotic currencies, such as the South Korean won, where there are few alternate methods for hedging exchange rate risk.

A money market hedge is a technique for hedging foreign exchange risk using the money market, the financial market in which highly liquid and short-term instruments like Treasury bills, bankers’ acceptances, and commercial paper are traded.

Since there are a number of avenues such as currency forwards, futures, and options to hedge foreign exchange risk, the money market hedge may not be the most cost-effective or convenient way for large corporations and institutions to hedge such risk. However, for retail investors or small businesses looking to hedge currency risk, the money market hedge is one way to protect against currency fluctuations without using the futures market or entering into a forward contract.

Forward Exchange Rates

Let’s begin by reviewing some basic concepts with regard to forward exchange rates, as this is essential to understand the intricacies of the money market hedge.

A forward exchange rate is merely the spot exchange (benchmark) rate adjusted for interest rate differentials. The principle of “Covered Interest Rate Parity” holds that forward exchange rates should incorporate the difference in interest rates between the underlying countries of the currency pair, otherwise an arbitrage opportunity would exist. 

For example, assume U.S. banks offer a one-year interest rate on U.S. dollar (USD) deposits of 1.5%, and Canadian banks offer an interest rate of 2.5% on Canadian-dollar (CAD) deposits. Although U.S. investors may be tempted to convert their money into Canadian dollars and place these funds in CAD deposits because of their higher deposit rates, they obviously face currency risk. If they wish to hedge this currency risk in the forward market by buying U.S. dollars one year forward, covered interest rate parity stipulates that the cost of such hedging would be equal to the 1% difference in rates between the U.S. and Canada.

We can take this example a step further to calculate the one-year forward rate for this currency pair. If the current exchange rate (spot rate) is US$1 = C$1.10, then based on covered interest rate parity, US$1 placed on deposit at 1.5% should be equivalent to C$1.10 at 2.5% after one year. Thus, it would be shown as:

US$1 (1 + 0.015) = C$1.10 (1 + 0.025), or US$1.015 = C$1.1275

And the one-year forward rate is therefore:

US$1= C$1.1275 ÷ 1.015 = C$1.110837

Note that the currency with the lower interest rate always trades at a forward premium to the currency with the higher interest rate. In this case, the U.S. dollar (the lower interest rate currency) trades at a forward premium to the Canadian dollar (the higher interest rate currency), which means that each U.S. dollar fetches more Canadian dollars (1.110837 to be precise) a year from now, compared with the spot rate of 1.10.

Money Market Hedge

The money market hedge works in a similar manner as a forward exchange, but with a few tweaks, as the examples in the next section demonstrate.

Foreign exchange risk can arise either due to transaction exposure (i.e., due to receivables expected or payments due in foreign currency) or translation exposure, which occurs because assets or liabilities are denominated in a foreign currency. Translation exposure is a much bigger issue for large corporations than it is for small business and retail investors. The money market hedge is not the optimal way to hedge translation exposure – since it is more complicated to set up than using an outright forward or option – but it can be effectively used for hedging transaction exposure.

If a foreign currency receivable is expected after a defined period of time and currency risk is desired to be hedged via the money market, this would necessitate the following steps:

Borrow the foreign currency in an amount equivalent to the present value of the receivable. Why the present value? Because the foreign currency loan plus the interest on it should be exactly equal to the amount of the receivable.

Convert the foreign currency into domestic currency at the spot exchange rate.

Place the domestic currency on deposit at the prevailing interest rate.

When the foreign currency receivable comes in, repay the foreign currency loan (from step 1) plus interest.

Similarly, if a foreign currency payment has to be made after a defined period of time, the following steps have to be taken to hedge currency risk via the money market:

Borrow the domestic currency in an amount equivalent to the present value of the payment.

Convert the domestic currency into the foreign currency at the spot rate.

Place this foreign currency amount on deposit.

When the foreign currency deposit matures, make the payment.

Note that although the entity who is devising a money market hedge may already possess the funds shown in step 1 above and may not need to borrow them, there is an opportunity cost involved in using these funds. The money market hedge takes this cost into consideration, thereby enabling an apples-to-apples comparison to be made with forward rates, which as noted earlier are based on interest rate differentials.

b) What is economic exposure and transaction exposure? How is economic exposure different from transaction exposure? 

Economic exposure is a type of foreign exchange exposure caused by the effect of unexpected currency fluctuations on a company’s future cash flows, foreign investments, and earnings. Economic exposure, also known as operating exposure, can have a substantial impact on a company’s market value since it has far-reaching effects and is long-term in nature. Companies can hedge against unexpected currency fluctuations by investing in foreign exchange (FX) trading.

The degree of economic exposure is directly proportional to currency volatility. Economic exposure increases as foreign exchange volatility increases and decreases as it falls. Economic exposure is obviously greater for multinational companies that have numerous subsidiaries overseas and a huge number of transactions involving foreign currencies. However, increasing globalization has made economic exposure a source of greater risk for all companies and consumers. Economic exposure can arise for any company regardless of its size and even if it only operates in domestic markets.

Unlike transaction exposure and translation exposure (the two other types of currency exposure), economic exposure is difficult to measure precisely and hence challenging to hedge. Economic exposure is also relatively difficult to hedge because it deals with unexpected changes in foreign exchange rates, unlike expected changes in currency rates, which form the basis for corporate budgetary forecasts.

For example, small European manufacturers that sell only in their local markets and do not export their products would be adversely affected by a stronger euro, since it would make imports from other jurisdictions such as Asia and North America cheaper and increase competition in European markets.

Economic exposure can be mitigated either through operational strategies or currency risk mitigation strategies. Operational strategies involve diversification of production facilities, end-product markets, and financing sources, since currency effects may offset each other to some extent if a number of different currencies are involved. Currency risk-mitigation strategies involve matching currency flows, risk-sharing agreements, and currency swaps.

Economic exposure can be mitigated either through operational strategies or currency risk mitigation strategies. Operational strategies involve diversification of production facilities, end-product markets, and financing sources.

Currency effects may offset each other to some extent if a number of different currencies are involved. Currency risk-mitigation strategies involve matching currency flows, risk-sharing agreements, and currency swaps. Matching currency flow means matching cash outflows and inflows with the same currency, such as doing as much business as possible in one currency, including borrowings. Currency swaps allow two companies to effectively borrow each other’s currencies for a period of time. 

Assume that a large U.S. company that gets about 50% of its revenue from overseas markets has factored in a gradual decline of the U.S. dollar against major global currencies—say 2% per annum—into its operating forecasts for the next few years. If the dollar appreciates instead of weakening gradually in the years ahead, this would represent economic exposure for the company. The dollar’s strength means that the 50% of revenues and cash flows the company receives from overseas will be lower when converted back into dollars, which will have a negative effect on its profitability and valuation.

Transaction exposure is the level of uncertainty businesses involved in international trade face. Specifically, it is the risk that currency exchange rates will fluctuate after a firm has already undertaken a financial obligation. A high level of vulnerability to shifting exchange rates can lead to major capital losses for these international businesses.

Transaction exposure is also known as translation exposure or translation risk.

The danger of transaction exposure is typically one-sided. Only the business that completes a transaction in a foreign currency may feel the vulnerability. The entity that is receiving or paying a bill using its home currency is not subjected to the same risk.

Usually, the buyer agrees to buy the product using foreign money. If this is the case, the hazard comes if that foreign currency should appreciate, as this would result in the buyer needing to spend more than they had budgeted for the goods.